Now Might Be a Good Time to Think About a Managed Option Strategy

By Nick Griebenow, CFA - Portfolio Manager - Shelton Capital                                        

It’s been smartly said that good investors take a snapshot in time and position their portfolios for what they think might change. For those capturing today’s moment, the image is more than a little hazy. Geopolitical concerns in the Middle East have pushed oil higher but prices are still down from their September peak. The worst bond rout in U.S. history has punished businesses in countless ways yet the S&P 500 is still up 9% for the year. Cash is king. A soft landing for the economy looks increasingly bumpy to many observers.  

In this environment it’s not at all surprising that investors are piling into cash. According to industry reports, money market funds have jumped to a near-record $5.6 trillion in assets. With rates over 5%, the short-term appeal is understandable. However, in the context of thoughtful investment plan and experienced financial advisor, we believe that covered call strategies may makes sense for certain investors. 

BACK IN THE SPOTLIGHT 

There’s a reason, investors and their advisors pushed over $26 billion into the now-$65-billion derivative income Morningstar Category in the last 12 months. Simply put, covered call strategies, which by definition sell away a degree of upside, tend to outperform in troubled times, like those we might expect as we enter 2024, although of course results may vary.  

IT’S ALL ABOUT RISK AND RETURN 

In basic terms, the strategy pairs a long equity position with a short call option on an equity security. If the stock goes up past the option’s strike price, upside is capped and while the covered call position does have a positive return it underperforms the stock itself. Should the stock go down, the premium collected will offset losses to an extent, giving the position an advantage over the stock itself. And should the stock go sideways, the investor benefits from the option premium. Since volatility often increases during sharp drawdowns, it is likely that higher call premiums have been collected in such an environment.

In the end, the often attractive premiums produced by an effective covered call strategy are simply compensation for smartly transforming risk, a concept really no different than the compensation investors expect to receive for taking on equity risk. Done well, that compensation can be attractive. 

SHOULD YOU OWN A COVERED-CALL FUND?

While it’s true the basics of a covered call strategy are straightforward, execution of a plan that can deliver high income while reducing downside risk requires a good degree of expertise, and time. Covered-call funds provide a vehicle that outsources those tasks while alleviating the problems that come with self-implementation. 

Writing calls is never a ‘set it and forget it’ strategy. Option research, daily monitoring, and regular trading take a certain level of expertise in the space and exposure to the platform. Not to be forgotten, of course, is the importance of the stocks selected for the strategy.  We believe a portfolio of value-oriented stocks with good fundamentals and good free cash flow are best when implementing a covered call strategy considering the pattern of returns it historically produces. Again, because covered call strategies are selling away some of a stock’s upside - we see little benefit to picking a highflyer stock that might double rather the names that are more stable with potential for capital appreciation.

BOTTOM LINE

We never know when we’re at the top or bottom of the market. No one rings a bell. But we do know with some certainty, if past experience holds true that covered call strategies can outperform in troubled times. If it’s true that covered calls, like all trades, are a study in risk versus return, then it might be time to take a deeper look at the potential of covered call strategies in this market environment.

Important Information

Options involve risk and are not suitable for everyone. Prior to buying or selling an option, your client must receive a copy of characteristics and risks of standardized options. Copies of this document may be obtained from any exchange on which options are traded or by contacting The Options Clearing Corporation, One North Wacker Dr., Suite 500, Chicago, IL 60606 (1-800-678-4667).

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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